In Undoing One Epic Mistake, Is The Fed Making Another?

Monetary Policy: The Fed's decision to hike its benchmark funds rate a quarter-point to a range of 1%-1.25% has been styled as a "normalization" of Fed policy. Maybe so. But it's also a tacit admission that its past policies were a mistake.

We say this because the Fed held interest rates steady at an unprecedented low rate of 0% for nearly eight years.

Yet, during that time, the economy never grew over 3% for a year and inflation stayed below the Fed's target of 2% a year, even as unemployment fell to a current 4.3% — which in the Fed's eyes equals "full employment."

On the surface, at least from the standpoint of inflation and unemployment, it looks like a success.

But it isn't. To give itself some maneuvering room, the Fed should have raised rates long ago when the economy's trajectory was clearly upward — 2013 comes to mind.

Now, with the economy looking a bit long in the tooth and some parts actually softening, the central bank is in a hurry to put as much space between the Fed funds rate and the zero-rate mistake as it can.

The logic for this is simple: The Fed needs room to cut rates when the next recession comes. But there's an irony there. By raising rates this late in a cycle, you significantly increase the chances of a recession.

For 10 years after the fiscal crisis hit, the Fed hiked rates just two times, careful not to upset the fragile recovery under President Obama who, with ObamaCare, Dodd-Frank and his regulatory frenzy, threw a wet blanket over the struggling economy.

Now, within the space of six months, we've had two more rate hikes. And the Fed has signaled that it likely will raise rates again in September. Indeed, based on the so-called "dot plot" median estimates of Fed policymakers, rates will keep rising until they reach 3% in 2019.

The rationale for this is that with unemployment now at 4.7% and falling, inflation pressures will soon start to rise, requiring the Fed to keep tightening to keep prices under control.

This set of conditions is what's known in economics as the "Phillips curve," which purports to show a trade-off between unemployment and inflation. That is, as unemployment falls, inflation rises. It's been a staple of economics for generations.

The only problem is, the Phillips curve has proven time and again to be false, and not useful as a predicting tool. Those who have used it to predict inflation — in particular the Fed — have proved disastrously wrong, repeatedly.

The Fed's target for inflation as measured by the personal consumption expenditures (PCE) deflator is 2%. But in the most recent month, the PCE rose just 1.7% year over year, a nothing number.

Consumer prices? They grew just 0.1% in April. So it's safe to say that, as of today, inflation is not a problem, and there are few signs of it on the horizon.

As for that dazzling 4.3% unemployment rate, as we've noted before, it's not a solid number. Data from our IBD/TIPP Poll of U.S. households, for instance, suggest that at least 21 million people are unemployed and want a job, not 7 million, as the official data show.

In point of fact, there's no real reason to be raising rates right now at all, except to undo the Fed's unadmitted but very real mistake of holding interest rates at an absurdly low 0% for the better part of a decade.

So, we wonder: In the Fed's desperation to restore "normal" policy, will it continue to raise interest rates, no matter what the economy does?

If so, will hiking of interest rates to slay the chimera of future inflation accidentally lead us into another recession?

Will its just-announced policy of drawing down its massive balance sheet lead to a liquidity crunch in the economy, exacerbating the impact of higher interest rates?

And will the Fed slam the brakes just as President Trump begins pushing through his high-growth agenda of deregulation, tax reform and spending restraint?

Don't misunderstand. We appreciate the Fed's dilemma and their desire to re-establish normal interest rates. And Fed Chair Janet Yellen has been measured in her approach, perhaps because her tenure at the head of the Fed is ending next year and she doubtless doesn't want to sink the economy.

That said, we hope Yellen & Co. don't feel that they have to get to the magic "neutral" fed funds rate of 3% by the end of next year, even if it means choking off economic growth.

That would be another huge mistake. The economy still has a lot of room to grow, actual unemployment is much higher than it appears, and inflation is not a huge problem. Give it room to breathe.

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